Magazine article The CPA Journal

Inbox: Letter to the Editor

Magazine article The CPA Journal

Inbox: Letter to the Editor

Article excerpt

In Defense of Fair Value

In "Accounting at a Crossroad" (December 2005), Eugene H. Flegm blames FASB and its standards on fairvalue accounting for enabling Enron and other contemporaneous frauds such as Qwest, Global Crossing, and Parmalat. That's like blaming fires on the inventor of matches.

Flegm has two major recommendations: 1) eliminate FASB and have the sec set the accounting rules; and 2) abandon fair-value accounting (except as to lower of cost or market for inventory and when stock is issued in a merger) and revert to historical cost accounting and the matching concept.

Historical cost accounting, and FASB's grotesque impairment standard (SFAS 144) that looks at undiscounted cash flows to determine whether cost of an asset is impaired, produce financial statements that in many cases are misleading.

For example, look at the financial statements of U.S. auto companies (Flegm worked at GM for several decades). Overcapacity in the auto industry, and attendant reduced or nonexistent margins, have been known facts for many years, but the U.S. auto industry has not responded by writing down plant costs. Balance sheets have been hugely overstated. Misleading.

The U.S. commercial airline industry had too many aircraft and too many seats. September 11 dramatically worsened the situation. Aircraft are parked in the desert, but owners of commercial aircraft as well as airline companies and their equipment lessors have been very slow to write down aircraft costs, if they have done so at all. Balance sheets have been hugely overstated. Misleading.

On the other side of the coin, consider the oil and gas industry. With oil at more than $50 a barrel and natural gas at more than $10 per thousand cubic feet (MCF), the financial statements of oil and gas companies based on historical cost, either successful efforts or full cost, are hugely understated. Misleading.

In the real estate industry, the cost of real estate owned by REITs is in many cases vastly less than fair value of the real estate. Misleading.

A final example. Dozens, probably hundreds, and maybe thousands of companies own valuable, highly salable intangible assets such as brands and patents, which are nowhere to be found on their balance sheets because those assets have no recorded historical cost. Misleading.

For balance sheets to have relevance to investors and creditors and rating agencies, historical cost of assets and historical proceeds of liabilities need to be replaced with fair value. I encourage CPA Journal readers to read the October 2005 submission by the Chartered Financial Analysts to FASB, in which the CFAs recommend fair-value accounting for all assets and liabilities. (see "A Comprehensive Business Reporting Model: Financial Reporting for Investors," CFA Centre for Financial Reporting, October 24, 2005, at

Flegm, along with other commentators, complains that Enron abused fair-value accounting by overstating assets. Enron exemplifies why auditors should not accept auditee companies' estimates of fair value of their assets (and liabilities). Had Arthur Andersen, Enron's auditor, required that Enron back up its estimates of the fair value of assets with written opinions from outside, independent valuation experts, these results could have been cited in Andersen's audit opinion and included in Enron's registration statements and Forms 10-K; Enron's abuse of fair value would not have happened and Arthur Andersen would still exist today. (CPAs are neither qualified nor competent to judge fair-value amounts ascribed to noncash assets and liabilities, thus the need for outside, independent valuation experts.) I was chief accountant at the SEC from January 1992 through March 1995. I wish that I had required Enron to get those opinions from outside, independent valuation experts and to include those opinions in its registration statements and 10-Ks; in such a case, the Enron debacle might not have happened. …

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